Much has already been reported about the impact that the Tax Cut and Jobs Act passed by Congress in December 2017 will have on individual taxpayers and companies, but there are also some factors regarding this legislation that investors should consider. Here are some key facts about the legislation and some perspective about how they could affect your investment strategy for 2018.

Key facts for investors

This is the second largest tax cut in history as a percentage of GDP; larger than the pro-growth 2003 tax cut and second only to Reagan’s 1981 cut.

The final package approved by the conference committee is larger and more pro-growth than either the House or Senate versions of the legislation.

U.S. companies can write off 100% of their capital equipment (capex) purchases for the next five years. The U.S. has never offered such a long tax-free runway for investments to be made and placed into service. This will be a useful experiment for future policy geared toward boosting the economy’s growth potential.

The effective tax rate on corporate dividends, which are subject to taxation at both the corporate and shareholder level, will fall from 50% to 40% due to the sharp drop in the corporate tax rate from 35% to 21%. The effective tax rate refers to the combined impact of the taxation at the corporate level and then the tax paid by investors when they receive the dividend. The last time taxes on dividends were cut significantly was in 2003. It reversed a long-term decline in the number of dividend payers and resulted in more S&P 500 companies paying a dividend.

Skepticism is widespread concerning the impact of this tax package on individuals. Yet, the 2018 impact is a $122.5 billion tax cut for individuals and small businesses. This is 0.6% of GDP, which is a notable benefit to consumers’ disposable income. Individual taxpayers will see larger standard deductions and family/child tax credits, but smaller deductions for home mortgage interest and state and local taxes.

The package includes international tax reforms to make U.S. companies more competitive globally. While multi-national companies faced a mandatory repatriation tax to bring back their foreign profits earned under the old system, they will now be able to earn profits overseas and return them to the U.S. tax free. The positive impact of this change is likely underestimated.

This legislation offers both cyclical stimulus and a likely secular boost in capital spending and investment. It is the latter effect that investors may be under-estimating, just as they did in 2003. We will describe below why the secular boost in potential GDP is the biggest story behind tax reform.

Impact on the economic cycle

The cyclical impacts of the Tax Cut and Jobs Act are fairly straightforward. First, the corporate tax cuts will positively impact corporate profits, and profits are a major driver of economic activity. We would argue that profits are at least as important as the consumer in economic impact, since most consumers owe their jobs and wages to the fact that they are employed at profitable companies. Researchers estimate the cut in the corporate tax rate from 35% to 21% will cut the effective rate paid by corporations by 3-6 percentage points. This will raise profits in 2018 by 7-12% over what they would have otherwise been. The profit improvement will tend to boost capex, wages, employment, dividends and share buybacks.

There is disagreement concerning how these profits will be used. We expect positive effects in all of the above areas, and initial public statements by a number of executives at major corporations support this. We will focus on the likelihood of capex growth, which some economists argue will not occur since an extended period of very low interest rates has not been effective in stimulating it. We point to several factors (not all inclusive) that should stimulate capex in 2018 even though we are likely in the latter stages of this economic cycle:

Capex can be expensed at a 100% rate in 2018, and for the following four years.

The small-business tax cut, under which pass-through businesses pay no tax on 20% of their income (with certain limitations), should also drive business expansion. This exemption combined with the reduced top individual tax rate of 37%, drops the small business tax rate by 10 percentage points to 29.6%.

Repatriation of corporations’ cash from oversees at a modest 14.5% tax rate may contribute to capex spending for companies desiring to expand or replace plant and equipment.

Higher disposable income in U.S. consumers’ pockets should increase demand. Anemic demand has been frequently cited as a major impediment to capital spending.

The secular story

We believe the most important story behind tax reform, and the one that should be of most interest to investors, involves its ability to boost the growth potential of the U.S. economy on a secular, or long-term, basis. Productivity is one of the two variables that determine potential GDP growth, the other being labor force growth. The size of the labor force is a given because it is determined by demographics. It is expected to grow at an average rate of just over 0.5% over the next decade.

Both variables have been sluggish in this economic cycle, leading to lower GDP growth potential (as well as low actual GDP growth). While labor force growth cannot be materially changed, economic policy can impact capital investment, which in turn can improve productivity. Improved productivity can drive higher potential GDP growth over many years. This is why the Tax Cut and Jobs Act is important. We are pleased to see economists and strategists raising their 2018 GDP forecasts to 3% or higher, a cyclical impact. We are much more encouraged that the major elements in this package provide the ingredients for boosting potential GDP growth in the U.S. by 1% or more for years to come. The investment implications of this are significant and positive for risk assets.

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The information, views, opinions, and positions expressed by the author and/or presented in the article are those of the author or individual who made the statement and do not necessarily reflect the policies, views, opinions, and positions of Hancock and Whitney Bank. Hancock and Whitney Bank make no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information presented. This information is general in nature and is provided for educational purposes only. Information provided and statements made should not be relied on or interpreted as accounting, financial planning, investment, legal, or tax advice. Hancock and Whitney Bank encourage you to consult a professional for advice applicable to your specific situation.